Quantitative Financial Risk Management: Theory and Practice

CHAPTER 3

Nonperforming Loans in the Bank Production Technology

Hirofumi Fukuyama

Fukuoka University

William L. Weber

Southeast Missouri State University

INTRODUCTION

Nonperforming loans are an undesirable by-product of the loan production process for financial institutions. Although collateral requirements can substitute for a borrower's lower probability of repayment (Saunders and Cornett 2008), financial institutions must still incur a charge when borrower's default. However, any attempt to eliminate nonperforming loans to zero would likely require financial institutions to employ large amounts of inputs to monitor borrowers or would require financial institutions to forgo some profitable lending. Both of these alternatives are likely inefficient. Instead, since bank owners choose the level of risk they wish to undertake (Hughes, Lang, Mester, and Moon, 1996), financial institutions should be willing to accept nonperforming loans up to the point where the lost income (including principal) on the marginal nonperforming loan is just offset by the reduced monitoring costs or by the increased interest income on the loan portfolio. In fact, policies that promote bank competition by reducing entry restrictions have the effect of reducing loan losses as well as the operating costs of production (Jayaratne and Strahan, 1998). Such competition can also be an effective means of weeding out managers who are weak at originating and monitoring the loan portfolio (Berger and Mester, 1997). ...